S&P 500

One of the Most Destructive Forces in Investing, and How to Fight it

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Quiz

You hold a diversified investment that performed poorly for 10 years and want to make a change. What should you do? (Multiple answers may be correct.)

  1. Very gradually diversify into more proven investments.
  2. Very gradually diversify by including stable investments.
  3. Compare the valuation of the investment along with the investment you are considering for diversification, and avoid selling low to buy high.
  4. Compare the valuation of the investment relative to the long run, and also the returns relative to full cycles. If both are below typical, don’t make changes, and keep saving new money into it.
  5. Track the valuations and recent performance relative to the long run / full cycles. Be ready to diversify from a point of strength – at a high point, adding investments that are not at a very high point.
  6. Avoid making changes due to cyclical forces.

One of the Most Destructive Forces in Investing, and How to Fight it

Have you ever experienced any of the following:

  1. Had some money to invest and looked at the past 1-, 5- or 10-year performance, to help choose?
  1. Heard from someone that she/he made big money in an investment in recent years and felt the urge to put some money there?
  1. Lived through a long period (as long as 10 or more years) of poor performance relative to other investments and felt that it’s time to diversify?
  1. Learned about an investment that grew phenomenally for the past 10 years, felt that it is a solid investment, and felt secure to put money there?
  1. Saw your investment go through a big crash (50%+), with economic news giving a thorough explanation for a disastrous future, leading you to seek safety in solid investments (e.g. bonds or CDs)?

From my experience talking to people over the years, the scenarios above are very common. Why is that? In most avenues of life you can use experiences from recent years to project the future. Examples:

  1. If you get hungry, you learn to eat and then feel better. It was true today, one year ago, and any day.
  1. If you cross a street without observing the traffic, and nearly get hurt, you learn to always look for traffic before crossing the street. This will never be bad advice.

It turns out that investments involve cycles of various lengths. This means that learning about past years can be counterproductive. Examples:

  1. US Large Growth (high Price/Book or Price/Earnings) stocks outperformed US Value stocks from 1982 to 2000. You would expect 18 years to be plenty long to establish the trend. In the following 2 years, the entire benefit of Growth stocks over Value stocks was wiped, and Value outperformed Growth for the full 20 years! This brought the relative performance of the two groups in line with the long run. Imagine the devastation of a person who made a change in early 2000 – something that many did. Today’s P/B of the S&P 500 is right near the peak level of 3/2000, early in its latest 10-year decline!
  1. Real estate had unusual gains from 1995 to 2006. Some people became multimillionaires by buying many houses with huge loans. By 2006, you could have taken a 106% loan on a house, with no verification of income. In the following 5-6 years, home prices declined by varying degrees, depending on location, taking as long as 10+ years peak-to-peak. In California, typical declines were 30% from peak to bottom. Some loans in 2006 led to more than 100% loss on the original investment, unless you had the income and discipline to keep paying the mortgage for years until recovery. This brought some of those millionaires to bankruptcy.

It is surprising to realize how many investment mistakes are rooted in a single cause – underestimating and misunderstanding cycles. So, how can you avoid the traps above?

  1. Always look for logic – not just past returns. Companies bring value through efficiently providing products and services. Real estate offers a place to live or run a business. Bonds are a loan to a company or government, allowing it to spend money that it doesn’t have with the hope of adding value beyond the cost of borrowing (or print money in the case of a government).
  1. Be highly suspicious of investments that don’t generate value or are too new to have at least one clear full cycle. Cryptocurrencies, including Bitcoin, have both issues. Educated opinion: only after completing the next tech downturn, you may reach a full crypto cycle.
  1. Study the long history of investment types that you are considering. If you notice unusually good or bad returns for an investment, compare them to the full cycle. If there is an unusually large deviation, at least prepare for the potential of a reversal. Do not move money out of an investment that did poorly for 10 or even 15 years relative to its full-cycle average, and into an investment that did very well in the past 10 or 15 years relative to its full-cycle average.
  1. Most common investments have a way to value them. Stocks have Price/Book Value (P/B) and Price/Earnings (P/E), representing what people pay for the stock relative to the intrinsic value or earnings of the company. For diversified collections of stocks, you can compare the current values relative to the full-cycle average, and don’t expect an anomaly to last forever. There are valuation measures for different types of real estate, small businesses, and other investments. Use them instead of looking at the recent past.
  1. Never judge an investment by the length of an unusual period – always view valuation measures. The longer the anomaly, the more violent the reversals tend to be, and the bigger the damage in counting on persistence after the anomaly sustained for a long time. If an anomaly continues another year, or multiple years, there is a growing temptation to take it as proof that it is a new normal, and so does the damage, when the reversal does come. You can observe the returns of Japanese stocks for nearly 30 years after 1989, or gold for nearly 30 years after 1980.
  1. Imagine that a diversified investment you are considering went through 10 terrible or phenomenal years of returns. If the terrible years make you want to avoid the investment and the phenomenal years make you want to put money there, recognize that you may have fallen into the traps above. Go back to logic, valuation measures and full cycles.

Quiz Answer

You hold a diversified investment that performed poorly for 10 years and want to make a change. What should you do? (Multiple answers may be correct.)

  1. Very gradually diversify into more proven investments.
  2. Very gradually diversify by including stable investments.
  3. Compare the valuation of the investment along with the investment you are considering for diversification, and avoid selling low to buy high. [Correct Answer]
  4. Compare the valuation of the investment relative to the long run, and also the returns relative to full cycles. If both are below typical, don’t make changes, and keep saving new money into it. [Correct Answer]
  5. Track the valuations and recent performance relative to the long run / full cycles. Be ready to diversify from a point of strength – at a high point, adding investments that are not at a very high point. [Correct Answer]
  6. Avoid making changes due to cyclical forces. [Correct Answer]

Explanations:

  1. You already hold a diversified investment. Not all extra diversification is good. If you sell low to buy high, the added risk and harm to the expected returns can outweigh the benefits of extra diversification. See all explanations below to help decide. Also note that reversals after 10 unusual years are the norm, not the exception.
  2. Buying a stable investment can prevent the damage of buying high in #1, but it still keeps the potential damage of selling low, and introduces the additional damage of low growth (that is typical for stable investments).
  3. Future returns do not always repeat recent years – reversals are the norm. A much better predictor of future returns is valuations (P/E, P/B, various real estate ROI and affordability measures). Valuations may fail for a streak of years, testing the discipline of investors, but the longer they fail the bigger the reversal tends to be. It is difficult to win by buying high.
  4. See explanation right above + stick to the foundations: high long-term returns for the asset class in which you are investing.
  5. See explanations above + you can add diversification without the damage of selling low and buying high, by being as patient as needed. Being impatient with this can create lifelong damage.
  6. There is always a compelling story justifying low points. While it may explain the past, it may not explain the future. Be extra wary of mistaking cyclical forces for permanence – it may be the most common mistake that people do at extremes (lows and highs).
Disclosures Including Backtested Performance Data

My Personal Experience with the Recency Bias

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Quiz!

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one.

My Personal Experience with the Recency Bias

What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.

How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.

Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.

Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:

  1. When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
  2. When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.

How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:

  1. Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
  2. Expecting low interest rates in the next few years.
  3. Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.

How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:

  1. Full cycle, long-term behavior.
  2. Logic.
  3. Valuations (e.g. Price/Book) today relative to typical in the past.

Quiz Answer:

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]

Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one. [The Correct Answer]

Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.

Read this month’s article to find out what leads people to pick the other option for both questions.

Disclosures Including Backtested Performance Data

What Moves Interest Rates?

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Quiz!

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal.
  4. A slight increase in unemployment.
  5. A severe recession in the US.
  6. Very high unemployment.

What Moves Interest Rates?

For a long time, some experts predicted a decline in interest rates. How could they be so wrong for so long? What really drives the Fed’s decisions?

Topic

Expectation

Reality

What are normal interest rates?

Very low, after 0% for years

Closer to the current 5.5%

What inflation is needed?

Declining inflation

An absolute level of 2%

What is the target inflation?

Higher than 2%, maybe 3%

2%

How does inflation change?

Linearly

The decline typically slows down as it approaches 2%

How are employment & inflation balanced?

Employment isn’t a big factor.

As long as inflation isn’t very high, we deserve low interest rates.

With unemployment so low, the main goal is to lower inflation

What are the Fed’s biases?

They want low interest rates

They don’t want to repeat the 1970’s where prematurely lowered rates let inflation spike again

What is good?

Low interest rates

Maximum employment with 2% inflation

Explanations: It seems that some people are driven by wishful thinking more than reality. Investors used the extremely low interest rates of the 2010s to justify extreme large US stock valuations, and they are eager to see interest rates go down. They hope to see very low interest rates as both the norm and the target. The Fed thinks very differently. They have two goals in mind (based on their job description): maximum employment and 2% inflation. With the employment goal in place, their focus is on getting inflation down. They saw inflation spike out of control in the 1970’s, and they are trying to avoid a repeat. The Fed said clearly that they will go as far as needed to reach their inflation goal.

What should we expect? Inflation is still nearly double its target: 3.5% vs. 2%. With inflation declines typically slowing down as we head towards the target 2%, we may have a long period with high interest rates. It is reasonable to expect the Fed to space out the rate increases further and further apart, as long as inflation keeps moderating. It may keep the interest rates the same for an extended period until inflation gets close to its target 2%.

Are there other scenarios? Yes. If the economy slows down and unemployment surges, the Fed will go back to a balancing act between employment and inflation, and could lower interest rates for a while. In that case, stock prices could do the opposite of mainstream expectations – they may decline. This could be most pronounced for stocks with the highest valuations (as measured by Price/Book).

Should we welcome lower interest rates? At first thought, lower interest rates are compelling, making it easier to fuel growth with cheap borrowing for companies & individuals. When considering the drivers of the Fed’s actions, lower interest rates without much lower inflation may be bad news – reflecting a response to a recession.

What can you do? You can structure your investments to benefit from high interest rates, and welcome the reality. Value stocks (with low price/book) tend to do unusually well with sustained high interest rates (not every month and not guaranteed). Note that your ideal investment allocation depends on your overall risk profile and goals.

Quiz Answer:

What are reasons for the Fed to lower interest rates? (There may be multiple correct answers.)

  1. A decline in Inflation.
  2. A mild recession in the US.
  3. Core PCE Inflation reaches the 2% goal. [Correct Answer]
  4. A slight increase in unemployment.
  5. A severe recession in the US. [Correct Answer]
  6. Very high unemployment. [Correct Answer]

Explanations:

  1. The Fed seeks 2% inflation, not just a decline in inflation. Declines can moderate interest rate increases and space them out more, but less likely to lead to a reversal long before approaching the target 2%.
  2. The Fed said repeatedly that it will accept a mild recession if needed to control inflation.
  3. When Core PCE Inflation reaches its 2% goal, interest rates don’t need to stay elevated and would likely move down.
  4. Slightly higher unemployment would still be low historically, and wouldn’t justify lower interest rates without much lower inflation.
  5. A severe recession would likely lead to lower interest rates, though not guaranteed if inflation spikes very high.
  6. Very high unemployment would likely lead to lower interest rates, especially if inflation isn’t very high.
Disclosures Including Backtested Performance Data

What is the Impact of High Inflation on Stock Returns?

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Quiz!

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations.
  2. Growth stocks.
  3. Value stocks.

What is the Impact of High Inflation on Stock Returns?

We are experiencing very high inflation, last seen in the early 1980’s. What is the Impact of High Inflation on Stock Returns?

  1. Negative: It hurts stocks, by reducing stock valuations (Price/Book) to reflect a lower value of future earnings. It hurts growth stocks with high valuations especially hard. Examples are S&P 500 and Nasdaq.
  2. Positive: It ultimately helps stocks, because high inflation = higher prices => higher earnings for the companies.

The bigger the spike in inflation, the more stocks are likely to decline in the short run, because the negative forces can be greater than the positive ones. Once stock valuations adjust to higher inflation and higher interest rates (that are used to combat inflation), the positive impact tends to be much stronger, especially for value stocks.

Key takeaways:

  1. When inflation spikes, you should be especially cautious of stocks with very high valuations. Now the largest tech stocks are priced extremely high, something familiar from past cycles. In the 1970’s, we had the nifty-fifty, also called “one-decision” stocks. Counter to expectations at the time, they crashed badly despite being the most prominent of US stocks (https://en.wikipedia.org/wiki/Nifty_Fifty). Stock returns adhere to the formula, price = book value x (price / book value). If the valuations (price / book value) are very high, even the best company in the world can see its stock price drop.
  2. Value stocks (with low valuations, or price / book-value) are better positioned for high inflation, for 2 reasons: (1) Immediate: there is no big correction necessary to valuations; (2) Ongoing: more of their earnings are from the near-term, with a smaller needed discount to future earnings.
  3. Even value stocks can be expensive at times. For example, US Large Value stocks are currently very expensive (but still less than the S&P 500 and Nasdaq). In stark contrast, non-US Value stocks are priced low.

Quiz Answer:

Which stocks are riskiest when inflation is high? (Note: stocks in each group are split between Growth and Value, with Value getting the lower Price/Book.)

  1. Value stocks that are priced far above their average valuations. [Correct Answer]
  2. Growth stocks. [Correct Answer]
  3. Value stocks.

Explanation:

  1. While value stocks tend to have low Price/Book, sometimes an entire collection of stocks becomes expensive, including value stocks. A current example is US Large stocks.
  2. Growth stocks tend to have earnings far into the future, that need to be discounted by high interest rates (the tool used to combat high inflation).
  3. Value stocks are priced lower and have nearer-term earnings that not impacted as much by higher interest rates. The increase in income (along with inflation) can become the dominant force.

See article for more explanations.

Disclosures Including Backtested Performance Data

S&P 500 10-Year Returns if The Past Repeats

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Quiz!

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6%
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1%

S&P 500 10-Year Returns if The Past Repeats

The S&P 500 enjoyed strong returns averaging 16.2% per year in the past 10 years. 10 years look like a long track record, enough to entice investing in the S&P 500 today, based on this data. Let’s evaluate this theory:

1. Actual book-value growth calculated at a mere 6%: What was the growth in the book value of the S&P 500 companies in the past 10 years? We can calculate it as the difference between compounding the 16.2% price increase per year and about 9.6% price/book increase per year (x2.5 going from under 2 to nearly 5), which is 6% per year. It turns out that the past 10 years were not very exciting for the S&P 500 companies.

2. Valuations declined 9.6% per year: From the most recent cycle when valuations reached today’s valuations (year 2000), they declined from about 5 to about 2 in 10 years, which is equal to -9.6% per year.

3. If the past repeats itself, we can get -3.3% annual decline for 10 years = -28% total: If the companies do as well as the past 10 years = 6% per year, and valuations revert to normal as happened last time we reached today’s valuations = -9.6% per year, we get an annual decline of -3.3% per year, and a total decline of -28%.

We don’t know what the future will actually be. But, if you are projecting the past to the future, you should prepare for material declines for the S&P 500 over the next 10 years.

Quiz Answer:

Question 1: In the past 10 years, how much did the S&P 500 companies grow their book values (change in price divided by change in price/book)?

  1. 16.2%
  2. 6% [Correct Answer]
  3. -6%

Question 2: Last time the S&P 500 had approximately today’s valuations, what was its average annual performance in the following 10 years?

  1. 16.2%
  2. 10%
  3. -1% [Correct Answer]

See article for more explanations.

Disclosures Including Backtested Performance Data